Can You Calculate How Much A Tenant Is Hurt When Its Exclusive Is Violated?

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This isn’t going to be a very satisfactory posting to those who like certainty.

How much does a tenant lose when its exclusive use rights are violated? No one knows because it can’t be known. Why is that – it’s because the crystal ball is broken. What’s more, you can’t even be sure that there will be a loss.

Let’s start with the second assertion, i.e., maybe there won’t be a loss. Perhaps, sales of the “exclusive” items will increase. Here’s the scenario for an increase. Assume that the store is located at less than vibrant shopping center and the “protected” tenant is selling $150 per square foot, year after year. Now, along comes a great “destination” retailer, one that customers seek out. It replaces an old-time tenant. It happens to sell a few of the protected items. Those items aren’t very central to the new store’s business, but it isn’t going to “pull” those SKUs.

What happens? The original tenant, i.e., the one whose exclusive use rights are being violated, now benefits (perhaps) in a large way by the added foot traffic and its overall business goes to $200 per square foot, a one-third increase. Sales of the protected items don’t go up by one-third; they only go up by 20%. Was the “protected” tenant hurt? It doesn’t seem so.

Rest be assured, there is no limit to the possible range of outcomes when another tenant causes the “exclusive use” items to be sold, even if the violation tramples the “protected” tenant’s primary business. How can that be? Here is a scenario. Let’s say you have bargained to be the only women’s shoe store at the property and along comes not just one, but two others. Now, customers looking to buy women’s shoes really, really have a reason to come to the property. They know it’s worth the trip. After all, if they don’t find a shoe they like in one of the competing stores, they can visit the other two, including that of the “protected” tenant.

Under those scenarios, sales can actually rise by a lot or by a little. Sales could fall by a lot or by a little. Again, who knows?

Does this mean that a tenant shouldn’t have a remedy? No. It bargained for an exclusive use right. In fact, it is paying for that right as part of its rent. That’s what the economists will tell you. That’s why the risk of a violator opening at the property, especially one that the landlord can stop, should fall on the landlord. That’s why it is called the tenant’s exclusive use “right.”

That entire lengthy preamble is the background for a common landlord position – “tenant, just prove your damages.” Well, here’s the problem – the “who knows” challenge not only covers predicting future losses at the time a lease is being negotiated, but also trying to calculate the loss or gain after a violation occurs. You say, give me an example. OK, here’s one for you.

A “protected” tenant’s sales were rising by 5% each year until a “violator” appeared at the shopping center. The following year, sales were flat. The rest of the chain had a drop in sales of 2% that same year, but stores within the chain had sales results ranging from up 10% to down 10%. Sales of the “exclusive use” products changed by about the same percentages. So, can this tenant “prove” its loss?

Suppose this store’s sales were up 8% and the protected products’ sales were up 7%. Maybe, had the competitors not arrived at the shopping center, sales would have been up 10% as would have been sales of the “protected items.” Maybe sales actually drop. Ask yourself, would they have dropped even more? Yes, who knows?

How do you make sense of this? If you concur that calculating actual damages is a “fool’s errand,” then whatever approach you take wherein a landlord is going to “pay” money to the tenant, either in the form of a check or as a rent credit, you’ll be looking at “liquidated damages.” Yes, pick a number that estimates what the tenant would lose. That’s called negotiating or bargaining. The tenant is entitled to compensation. It was induced to sign its lease based on its concern that without protection for some of its goods/services or for its primary business. Since you can’t tell what the result might be or even what it turned out to be, the tenant should get the benefit of what it bargained for.

But, how much? We don’t know. Here, however, is a little guidance. Make the assumption that there will be a loss in sales of the protected items. Pick a hypothetical percentage loss, say 10% of those items. Calculate the loss in gross margin for those products. That’s the loss. Use that as a start for the bargaining. Here’s an example. The tenant sells $10,000 a month of the “protected” items. Assume sales could fall by as much as 10%, that’s $1,000 a month in lost sales. The gross margin is 50% (that translates from a markup of 100%). That’s a loss of $500 a month in profit. So, cut the rent by $500 a month. Why use “gross margin” and not “profit”? That’s because when sales are loss, the seller loses not only the “profit,” but also the money that paid the rent and other expenses. That portion is called “contribution to overhead.” It is a real loss because the “overhead” doesn’t go down and not the remaining sales have to cover the same overhead cost.

How does that work when the parties talk about a remedy of going to “half” rent? Well, it depends on the rent. If the rent were $1000 a month, half rent would make sense if the loss of gross margin were $500 a month. If the rent were $2,000 a month, half rent wouldn’t make sense. If the loss were $750 a month, it wouldn’t make sense.

Let’s test the numbers. Assume that the rent should be about 5% of sales. A store paying $1000 a month, $12,000 a year, would correspond to annual sales of $240,000 a year. That makes sense. A tenant selling only $120,000 a year of merchandise would reasonably take space costing $6,000 a year – $500 a month.

So, what about going to “percentage rent”? A drop in sales of $1,000 a month would drop the rent by only $50. That’s a far cry from the $500 that’s being lost. So, a tenant whose sales are at the level where the agreed-upon percentage results in the same rent as the “Fixed Rent,” would only get a $50 a month rent reduction while losing $500 a month. If the tenant’s sales were well below the “break even” point, i.e., 5% of its sales would only come to half the rent it is paying, then going to percentage rent would cut the rent in half. That’s the right result in out example, but we got there in a way that has no relationship to the exclusive use violation itself.

Where does this seem to come out? If the tenant is going to get a rent reduction or a check from the landlord, what’s the justification if you can’t figure out what’s a fair amount and, in fact, you can’t even figure out if the tenant was harmed. Perhaps it is to give the landlord a financial incentive to do something about the violation. Let’s just say that part of the rent is for “insurance.” The tenant pays an insurance premium to the landlord who, as the insurer, will pay out if the insured-against event happens. And, in many, if not most, cases, the insurer-landlord actually has some control over whether there will be a violation in the first place. That’s not in every case, but “insurance” is to cover risk.

Is this an open-ended “check”? No. The landlord’s protection against a tenant taking advantage of the situation would come in bargaining for an “end” to the rent reductions or “damage” payments. It has to say: “tenant, you need to decide if you are going to stay at the property. We’ll give you a year (or two or whatever) to stay at the reduced rent (or to receive the periodic damage payments). Then, you can leave or stay. If you stay, the damage payments or rent reductions end.”

Does anyone have a better theory?

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Comments

  1. Ira:
    I am also concerned about the investment made in the premises. How do you address various levels of LHI? And what about opportunities lost? I pick this site and pass up other potentially viable sites that are now no longer available.

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